Fearing China Earnings, Investors Turn to US Small Caps

Investors, worried about China's slowing economy and Europe's debt crisis, appear to be tiptoeing into a little-loved sector — U.S. small caps.

The Russell 2000 small-cap index rose 3 points Thursday to 829, while the major stock market indices were lower or flat. The Dow was down 18 at 13, 326, and the Nasdaq was down 2 at 3049. The S&P 500 was fractionally changed, up just 0.28 points at 1432.84. This follows Wednesday's slight, one point decline in the Russell, while the rest of the market was sharply lower.

In the past five days, the S&P 500 lost 2 percent, while small caps were down just 1.8 percent. The small-cap energy sector was actually up 0.3 percent while mega caps are down 1.5 percent, and small-cap consumer discretionary stocks are down 1.5 percent, while the larger cap discretionary sector is down 2.6 percent in the same period.

"When you see a down tape, you expect the small caps to get hit a little bit harder. This is interesting, " said Lori Calvasina, small-cap and mid-cap equity strategist at Credit Suisse. "Generally, what we've found when you start to see this behavior is the domestic trade."

The comments from big U.S. companies with foreign earnings exposure just in the past week shows a worrying trend. The latest was Advanced Micro Devices which said late Thursday that its third quarter revenue will probably be 10 percent lower than last quarter due to the weak global economy and also as more consumers choose tablets, over PCs. Engine maker Cummins also warned about slowing growth, as did Alcoa and Avnet . Friday earnings reports include JPMorgan Chase, and Wells Fargo, before the opening bell.

"We had trouble all year breaking through that 850 barrier (on the Russell), and finally it broke through it in the middle of September, and got up to 865, and then we eased back, " she said. "I think you've got a lot of nervousness coming up to earnings. With small caps, you don't have to worry so much because they're more domestic and you don't have a lot of international exposure." She said the Russell 2000 stocks generate just 19 percent of their revenues internationally. As for the S&P 500, 46 percent of revenues are from overseas sources.

Goldman Sachs analysts Thursday issued a note on small-cap opportunities, in stocks with market capitalizations of less than $3.5 billion. The analysts noted that only a quarter of the small cap managers are beating their benchmarks for the year. They pointed out that investors are most overweight industrials and materials, but underweight health care and financials, two of the three best performing sectors so far this year.

"The stock-picking environment for small caps has improved on both an absolute and relative basis to large caps, " the Goldman analysts wrote. "Indeed, the three-month correlation for the Russell 2000 are at three-year lows. When looking at dispersion of returns … we note that they remain most acute in energy and health care."

The Goldman analysts recommend "under-earners, " companies with room for margin expansion, like Owens Illinois, Global Payments, and Manitowoc . They also like companies with attractive yields and dividend growth like Great Plains Energy and Cinemark . Other names on their "Conviction Buy" list include Domino's Pizza, PerkinElmer, Tenneco, Volcano Corp., SunCoke Energy, and NeuStar .

Calvasina said she is maintaining her 850 target on the Russell. "We're not changing our target but we can't get bearish right now ... and I'm kind of a bearish person by nature, " said Calvasina.

She said her quarterly survey of small cap investors showed that 56 percent said in September that they were bullish over the next six months, compared to 40 percent in her second quarter survey. Unlike other surveys, she said her survey of about 100 clients is not contrarian when it comes to bullishness.

Small caps are out of favor among many investors who were interested in the high quality big cap names and dividend payers this year. "People can talk about large caps all they want, but that's not really happened this year. The smaller you go down in terms of market cap, the more domestic you are and you really saw microcaps doing well when the domestic theme picked up. And the only place you saw inflows was into small cap ETFs. The active managers haven't gotten the inflows."

Microcaps are up 17 percent year-to-date, while the Russell 2000 is up 12 percent and the S&P is up 14 percent. The Nasdaq is also up 17 percent. Calvasina said the names that were most widely held by small-cap funds underperformed in the second quarter, but made a comeback in the third quarter.

Some of those most widely held include Hexcel, Genessee and Wyoming, Netgear, Dana Holding, and Portfolio Recovery .

"The market's going up but people are pretty much risk averse ... I think we're still in the middle of something that hasn't played out yet, " she said. She said some investors expect a big sell-off and are looking for a buying opportunity in small cap names later this year. But she said she's not sure that sell-off is going to be all that big.

"I don't think they're going to blow up. I don't think they're going to see a lot of fast money in there right now, " she said. "I don't get a lot of calls from the multi-cap investors or the hedge fund crowd … I feel the only people interested in small caps right now are the small cap guys."

She said the multiple of small caps, like the rest of the market, is down from where it was in the spring of 2011, when it was at 17.7. It's now at a price-to-earnings ratio of 14.7. Among the sectors that could see upside is energy, she said. In the small cap universe, the energy sector represents a lot of the U.S. natural gas industry, as opposed to the multinational oil companies of the S&P 500.

"Energy was at a historical low relative to the Russell on a valuation basis. It's at a historical low on earnings momentum. I just think it got way too out of favor, " she said. Year-to-date, Russell 2000 energy stocks are down 3.4 percent, compared to the 5 percent gain in the S&P energy sector.

What Else to Watch

Thursday evening's vice presidential debate promises to be a topic du jour Friday, after the presidential debate last week boosted Republican Mitt Romney's showing in the polls. Investors played the turn by buying stocks that would benefit from a Republican White House . President Barack Obama's poor performance sent Democrat-favored sectors lower.

Besides the big bank earnings before the bell, there is also producer price inflation data at 8:30 a.m. ET. Consumer sentiment is reported at 9:55 a.m.